[FONT="]Commodity Investments –do they make sense?[/FONT]
[FONT="]Investors may be considering making investments into commodities through Exchange Traded Funds (ETFs) yet in my experience, many lack a full understanding of the potential hidden costs associated with these investments.[/FONT]
[FONT="]If one could invest directly into the underlying commodity at the spot price, the conclusions reached here might be different. However, to invest in the spot price one needs to take (or be able to take) physical delivery of the underlying commodity. Whilst this might be practical for certain commodities such as gold or silver, it certainly isn’t practical for oil, corn, wheat or gas etc. Retail investors will therefore typically look to options such as an ETF to gain access to their commodity of choice. It is for this reason that they need to understand the differences between the commodity spot prices and the rolling futures contract. [/FONT]
[FONT="]The performance of a commodity ETF is largely dependent on three variables: [/FONT]
[FONT="]1)[/FONT][FONT="]Changes in the spot price, [/FONT]
[FONT="]2)[/FONT][FONT="]Interest income on un-invested cash, and [/FONT]
[FONT="]3)[/FONT][FONT="]The ‘roll yield’[/FONT]
[FONT="]While the first two are easily understood by most investors, the roll yield is more complex. [/FONT][FONT="]
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[FONT="]By way of an illustration of the possible impact, we looked at the difference between rolling over a futures contract compared to the spot price of sugar between April 2004 and December 2008: [/FONT]
[FONT="]In this example, the impact of the roll yield was very significant and you would have been down 126% compared to the spot price of sugar over this period.[/FONT]
[FONT="]Of course the reverse is also true and a large contributor to differences in commodity futures returns has been the return derived from rolling futures contracts before they expire because this roll return can also be positive. This has been the case with many markets (such as those for energy contracts) in the past. [/FONT]
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The message here is that investors considering investing in a commodity ETF should most definitely be interested in the shape of the curve of forward contracts. [/FONT]
[FONT="]Conclusions[/FONT]
[FONT="]At first sight, commodity investments appear to have some interesting investment characteristics. However, they are totally reliant, in terms of price performance, on what the next investor will pay for them. There might be a risk premium embedded in them, but it is far from clear to what extent this can disappear during inflows of “hot money”. That is to say that the delicate balance between hedgers and speculators can be easily unbalanced. [/FONT]
[FONT="]Remember that past performance is no guarantee of future returns and just because commodity investment may have delivered good returns for investors in the past, does not mean that the same will be true in the future.[/FONT]
[FONT="]Finally, a study in 2004 found the average excess return from commodities was not reliably different to zero and there is also little evidence to support commodities' reputation as a diversifier and inflation hedge.[/FONT]
[FONT="]I have analysed the CRB Commodity Index in US$ since 1956 with the following results:[/FONT]
[FONT="]Monthly data Oct 1956 to Jan 2009[/FONT]
[FONT="]One month Treasury Bills
Annualised return 5.25%pa
Annualised standard deviation 0.79%[/FONT]
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[FONT="]CRB Commodity Index
[/FONT][FONT="]Annualised return [/FONT][FONT="]1.37%pa[/FONT]
[FONT="]Annualised standard deviation 11.69%
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[FONT="]What this means is that, on average, an investment in commodities does not appear to reliably offer an expected premium above cash rates. Investment is therefore pure speculation, for every long position there is a short. For you to win on your bet that the price will rise, I have to lose my bet that the price will fall. Over the long run, the average expected return from all the bets placed is zero, less the costs of engaging in the process - which as we have seen can be considerable.[/FONT]
[FONT="]Commodity investments might make sense if you could buy at close to the spot price and avoid storage and insurance costs. This is where certain options like investing in bullion might give investors a sporting chance.[/FONT]